DERIVATIVES AND HEDGE ACCOUNTING

12 Months Ended

Dec. 31, 2012

DERIVATIVES AND HEDGE ACCOUNTING

DERIVATIVES AND HEDGE ACCOUNTING

12. DERIVATIVES AND HEDGE ACCOUNTING

We use derivatives and other financial instruments as part of our financial risk management programs and as part of our investment operations. Interest rate, currency, equity and commodity swaps, credit contracts (including the super senior credit default swap portfolio), swaptions, options and forward transactions are accounted for as derivatives recorded on a trade-date basis, and carried at fair value. Unrealized gains and losses are reflected in income, when appropriate. In certain instances, a contract's transaction price is the best indication of initial fair value. Aggregate asset or liability positions are netted on the Consolidated Balance Sheet only to the extent permitted by qualifying master netting arrangements in place with each respective counterparty. Cash collateral posted with counterparties in conjunction with transactions supported by qualifying master netting arrangements is reported as a reduction of the corresponding net derivative liability, while cash collateral received in conjunction with transactions supported by qualifying master netting arrangements is reported as a reduction of the corresponding net derivative asset.

Derivatives, with the exception of bifurcated embedded derivatives, are reflected in the Consolidated Balance Sheet in Derivative assets, at fair value and Derivative liabilities, at fair value. A bifurcated embedded derivative is measured at fair value and accounted for in the same manner as a free standing derivative contract. The corresponding host contract is accounted for according to the accounting guidance applicable for that instrument. A bifurcated embedded derivative is generally presented with the host contract in the Consolidated Balance Sheet. See Note 6 herein for additional information on embedded policy derivatives.

The following table presents the notional amounts and fair values of our derivative instruments:

	December 31, 2012								December 31, 2011
	Gross Derivative Assets				Gross Derivative Liabilities				Gross Derivative Assets				Gross Derivative Liabilities
(in millions)	Notional Amount		Fair Value(a)		Notional Amount		Fair Value(a)		Notional Amount		Fair Value(a)		Notional Amount		Fair Value(a)
Derivatives designated as hedging instruments:
Interest rate contracts(b)	$	–	$	–	$	–	$	–	$	–	$	–	$	481	$	38
Foreign exchange contracts		–		–		–		–		–		–		180		1
Derivatives not designated as hedging instruments:
Interest rate contracts(b)		63,463		6,479		63,482		5,806		72,660		8,286		73,248		6,870
Foreign exchange contracts		8,325		104		10,168		174		3,278		145		3,399		178
Equity contracts(c)		4,990		221		25,626		1,377		4,748		263		18,911		1,126
Commodity contracts		625		145		622		146		691		136		861		146
Credit contracts		70		60		16,244		2,051		407		89		25,857		3,366
Other contracts(d)		20,449		38		1,488		206		24,305		741		2,125		372
Total derivatives not designated as hedging instruments		97,922		7,047		117,630		9,760		106,089		9,660		124,401		12,058
Total derivatives	$	97,922	$	7,047	$	117,630	$	9,760	$	106,089	$	9,660	$	125,062	$	12,097

(a)     Fair value amounts are shown before the effects of counterparty netting adjustments and offsetting cash collateral.

(b)     Includes cross currency swaps.

(c)     Notional amount of derivative liabilities and fair values of derivative liabilities include $23 billion and $1.3 billion, respectively, at December 31, 2012 and $18.3 billion and $0.9 billion, respectively at December 31, 2011 related to bifurcated embedded derivatives. A bifurcated embedded derivative is generally presented with the host contract in the Consolidated Balance Sheet.

(d)     Consist primarily of contracts with multiple underlying exposures.

The following table presents the fair values of derivative assets and liabilities in the Consolidated Balance Sheet:

	December 31, 2012										December 31, 2011
	Derivative Assets					Derivative Liabilities					Derivative Assets					Derivative Liabilities
(in millions)	Notional Amount		Fair Value			Notional Amount		Fair Value			Notional Amount		Fair Value			Notional Amount		Fair Value
Global Capital Markets derivatives:
AIG Financial Products	$	59,854	$	4,725		$	66,717	$	5,506		$	86,128	$	7,063		$	90,241	$	8,853
AIG Markets		14,028		1,308			18,774		1,818			7,908		1,409			8,201		1,168
Total Global Capital Markets derivatives		73,882		6,033			85,491		7,324			94,036		8,472			98,442		10,021
Non-Global Capital Markets derivatives(a)		24,040		1,014			32,139		2,436			12,053		1,188			26,620		2,076
Total derivatives, gross	$	97,922		7,047		$	117,630		9,760		$	106,089		9,660		$	125,062		12,097
Counterparty netting(b)				(2,467	)				(2,467	)				(3,660	)				(3,660	)
Cash collateral(c)				(909	)				(1,976	)				(1,501	)				(2,786	)
Total derivatives, net				3,671					5,317					4,499					5,651
Less: Bifurcated embedded derivatives				–					1,256					–					918
Total derivatives on consolidated balance sheet			$	3,671				$	4,061				$	4,499				$	4,733

(a)     Represents derivatives used to hedge the foreign currency and interest rate risk associated with insurance as well as embedded derivatives included in insurance contracts. Liabilities include bifurcated embedded derivatives, which are recorded in Policyholder contract deposits.

(b)     Represents netting of derivative exposures covered by a qualifying master netting agreement.

(c)     Represents cash collateral posted and received that is eligible for netting.

Collateral

We engage in derivative transactions directly with unaffiliated third parties in most cases under International Swaps and Derivatives Association, Inc. (ISDA) agreements. Many of the ISDA agreements also include Credit Support Annex (CSA) provisions, which generally provide for collateral postings at various ratings and threshold levels. We attempt to reduce our risk with certain counterparties by entering into agreements that enable collateral to be obtained from a counterparty on an upfront or contingent basis. We minimize the risk that counterparties to transactions might be unable to fulfill their contractual obligations by monitoring counterparty credit exposure and collateral value and generally requiring additional collateral to be posted upon the occurrence of certain events or circumstances. In addition, a significant portion of the derivative transactions have provisions that require collateral to be posted upon a downgrade of our long-term debt ratings or give the counterparty the right to terminate the transaction. In the case of some of the derivative transactions, as an alternative to posting collateral and subject to certain conditions, we may assign the transaction to an obligor with higher debt ratings or arrange for a substitute guarantee of our obligations by an obligor with higher debt ratings or take other similar action. The actual amount of collateral required to be posted to counterparties in the event of such downgrades, or the aggregate amount of payments that we could be required to make, depends on market conditions, the fair value of outstanding affected transactions and other factors prevailing at and after the time of the downgrade.

Collateral posted by us to third parties for derivative transactions was $4.5 billion and $4.7 billion at December 31, 2012 and December 31, 2011, respectively. This collateral can generally be repledged or resold by the counterparties. Collateral obtained by us from third parties for derivative transactions was $1.4 billion and $1.6 billion at December 31, 2012 and December 31, 2011, respectively. We generally can repledge or resell this collateral.

Hedge Accounting

We designated certain derivatives entered into by GCM with third parties as fair value hedges of available-for-sale investment securities held by our insurance subsidiaries. The fair value hedges include foreign currency forwards designated as hedges of the change in fair value of foreign currency denominated available-for-sale securities attributable to changes in foreign exchange rates. We previously designated certain interest rate swaps entered into by GCM with third parties as cash flow hedges of certain floating rate debt issued by ILFC, specifically to hedge the changes in cash flows on floating rate debt attributable to changes in the benchmark interest rate. We de-designated such cash flow hedges in December 2012 subsequent to the announcement of the ILFC Transaction.

We use foreign currency denominated debt and cross-currency swaps as hedging instruments in net investment hedge relationships to mitigate the foreign exchange risk associated with our non-U.S. dollar functional currency foreign subsidiaries. We assess the hedge effectiveness and measure the amount of ineffectiveness for these hedge relationships based on changes in spot exchange rates. For the years ended December 31, 2012, 2011, and 2010 we recognized gains (losses) of $(74) million, $(13) million and $28 million, respectively, included in Foreign currency translation adjustment in Accumulated other comprehensive income related to the net investment hedge relationships.

A qualitative methodology is utilized to assess hedge effectiveness for net investment hedges, while regression analysis is employed for all other hedges.

The following table presents the effect of our derivative instruments in fair value hedging relationships in the Consolidated Statement of Operations:

Years Ended December 31, (in millions)	2012			2011
Interest rate contracts:(a)
Loss recognized in earnings on derivatives	$	–		$	(3	)
Gain recognized in earnings on hedged items(b)		124			152
Foreign exchange contracts:(a)
Loss recognized in earnings on derivatives		(2	)		(1	)
Gain recognized in earnings on hedged items		2			1

(a)     Gains and losses recognized in earnings for the ineffective portion and amounts excluded from effectiveness testing, if any, are recorded in Net realized capital gains (losses).

(b)     Includes $124 million and $149 million, for the years ended December 31, 2012 and 2011, respectively, representing the amortization of debt basis adjustment recorded in Other income and Net realized capital gains (losses) following the discontinuation of hedge accounting.

The following table presents the effect of our derivative instruments in cash flow hedging relationships in the Consolidated Statement of Operations:

Years Ended December 31, (in millions)	2012			2011
Interest rate contracts(a):
Gain (loss) recognized in OCI on derivatives	$	(2	)	$	(5	)
Gain (loss) reclassified from Accumulated OCI into earnings(b)		(35	)		(55	)

(a)     Hedge accounting was discontinued in December 2012 subsequent to the announcement of the ILFC Transaction. Gains and losses recognized in earnings are recorded in Income (loss) from discontinued operations. Previously the effective portion of the change in fair value of a derivative qualifying as a cash flow hedge was recorded in Accumulated other comprehensive income until earnings were affected by the variability of cash flows in the hedged item. Gains and losses reclassified from Accumulated other comprehensive income were previously recorded in Other income. Gains or losses recognized in earnings on derivatives for the ineffective portion were previously recorded in Net realized capital gains (losses).

(b)     Includes $19 million for the year ended December 2012, representing the reclassification from Accumulated other comprehensive income into earnings following the discontinuation of cash flow hedges of ILFC debt.

Derivatives Not Designated as Hedging Instruments

The following table presents the effect of our derivative instruments not designated as hedging instruments in the Consolidated Statement of Operations:

	Gains (Losses) Recognized in Earnings
Years Ended December 31, (in millions)
	2012			2011
By Derivative Type:
Interest rate contracts(a)	$	(241	)	$	603
Foreign exchange contracts		96			137
Equity contracts(b)		(641	)		(263	)
Commodity contracts		(1	)		4
Credit contracts		641			337
Other contracts		6			47
Total	$	(140	)	$	865
By Classification:
Policy fees	$	160		$	113
Net investment income		5			8
Net realized capital gains (losses)		(672	)		248
Other income (losses)		367			496
Total	$	(140	)	$	865

(a)     Includes cross currency swaps.

(b)     Includes embedded derivative losses of $166 million and $397 million for the years ended December 31, 2012 and 2011, respectively.

Global Capital Markets Derivatives

GCM enters into derivative transactions to mitigate market risk in its exposures (interest rates, currencies, commodities, credit and equities) arising from its transactions. At December 31, 2012, GCM has entered into credit derivative transactions with respect to $67 million of securities to economically hedge its credit risk. In most cases, GCM has not hedged its exposures related to the credit default swaps it had written.

GCM follows a policy of minimizing interest rate, currency, commodity, and equity risks associated with investment securities by entering into offsetting positions, thereby offsetting a significant portion of the unrealized appreciation and depreciation.

Super Senior Credit Default Swaps

Credit default swap transactions were entered into with the intention of earning revenue on credit exposure. In the majority of these transactions, we sold credit protection on a designated portfolio of loans or debt securities. Generally, such credit protection was provided on a "second loss" basis, meaning we would incur credit losses only after a shortfall of principal and/or interest, or other credit events, in respect of the protected loans and debt securities, exceeded a specified threshold amount or level of "first losses."

The following table presents the net notional amount, fair value of derivative liability and unrealized market valuation gain of the super senior credit default swap portfolio, including credit default swaps written on mezzanine tranches of certain regulatory capital relief transactions, by asset class:

									Unrealized Market Valuation Gain(c)
					Fair Value of Derivative Liability at(b)(c)
	Net Notional Amount(a)
									Years Ended December 31,
	December 31, 2012		December 31, 2011		December 31, 2012		December 31, 2011
(in millions)									2012		2011
Regulatory Capital:
Corporate loans	$	–	$	1,830	$	–	$	–	$	–	$	–
Prime residential mortgages		97		3,653		–		–		–		6
Other		–		887		–		9		9		8
Total		97		6,370		–		9		9		14
Arbitrage:
Multi-sector CDOs(d)		3,944		5,476		1,910		3,077		538		249
Corporate debt/CLOs(e)		11,832		11,784		60		127		67		44
Total		15,776		17,260		1,970		3,204		605		293
Mezzanine tranches		–		989		–		10		3		32
Total	$	15,873	$	24,619	$	1,970	$	3,223	$	617	$	339

(a)     Net notional amounts presented are net of all structural subordination below the covered tranches. The decrease in the total net notional amount from December 31, 2011 to December 31, 2012 was due primarily to terminations of $5.4 billion and amortization of $3.2 billion.

(b)     Fair value amounts are shown before the effects of counterparty netting adjustments and offsetting cash collateral.

(c)     Includes credit valuation adjustment gains (losses) of $(39) million and $26 million for the years ended December 31, 2012 and 2011, respectively, representing the effect of changes in our credit spreads on the valuation of the derivatives liabilities.

(d)     During 2012, a super senior CDS transaction with a net notional amount of $470 million was terminated at approximately its fair value at the time of termination. As a result, a $416 million loss, which was previously included in the fair value derivative liability as an unrealized market valuation loss, was realized. During 2012, $213 million was paid to counterparties with respect to multi-sector CDOs. Upon payment, a $213 million loss, which was previously included in the fair value of the derivative liability as an unrealized market valuation loss, was realized. Multi-sector CDOs also include $3.4 billion and $4.6 billion in net notional amount of credit default swaps written with cash settlement provisions at December 31, 2012 and December 31, 2011, respectively. Collateral postings with regards to multi-sector CDOs were $1.6 billion and $2.7 billion at December 31, 2012 and December 31, 2011, respectively.

(e)     Corporate debt/CLOs include $1.2 billion in net notional amount of credit default swaps written on the super senior tranches of CLOs at both December 31, 2012 and December 31, 2011. Collateral postings with regards to corporate debt/CLOs were $420 million and $477 million at December 31, 2012 and December 31, 2011, respectively.

The expected weighted average maturity of the super senior credit derivative portfolios as of December 31, 2012 was less than one year for the regulatory capital prime residential mortgage portfolio, 6 years for the multi-sector CDO arbitrage portfolio and 3 years for the corporate debt/CLO portfolio.

Given the current performance of the underlying portfolios, the level of subordination of the credit protection written and the assessment of the credit quality of the underlying portfolio, as well as the risk mitigants inherent in the transaction structures, we do not expect that we will be required to make payments pursuant to the contractual terms of those transactions providing regulatory relief.

Because of long-term maturities of the CDS in the arbitrage portfolio, we are unable to make reasonable estimates of the periods during which any payments would be made. However, the net notional amount represents the maximum exposure to loss on the super senior credit default swap portfolio.

Written Single Name Credit Default Swaps

We have also entered into credit default swap contracts referencing single-name exposures written on corporate, index and asset-backed credits with the intention of earning spread income on credit exposure. Some of these transactions were entered into as part of a long-short strategy to earn the net spread between CDS written and purchased. At December 31, 2012, the net notional amount of these written CDS contracts was $410 million, including ABS CDS transactions purchased from a liquidated multi-sector super senior CDS transaction. These exposures have been partially hedged by purchasing offsetting CDS contracts of $51 million in net notional amount. The net unhedged position of $359 million represents the maximum exposure to loss on these CDS contracts. The average maturity of the written CDS contracts is 4 years. At December 31, 2012, the fair value of derivative liability (which represents the carrying value) of the portfolio of CDS was $48 million.

Upon a triggering event (e.g., a default) with respect to the underlying credit, we would have the option to either settle the position through an auction process (cash settlement) or pay the notional amount of the contract to the counterparty in exchange for a bond issued by the underlying credit obligor (physical settlement).

These CDS contracts were written under ISDA Master Agreements. The majority of these ISDA Master Agreements include credit support annexes (CSAs) that provide for collateral postings at various ratings and threshold levels. At December 31, 2012, collateral posted by us under these contracts was $64 million prior to offsets for other transactions.

All Other Derivatives

Our businesses, other than GCM, also use derivatives and other instruments as part of their financial risk management. Interest rate derivatives (such as interest rate swaps) are used to manage interest rate risk associated with embedded derivatives contained in insurance contract liabilities, fixed maturity securities, outstanding medium- and long-term notes as well as other interest rate sensitive assets and liabilities. Foreign exchange derivatives (principally foreign exchange forwards and options) are used to economically mitigate risk associated with non-U.S. dollar denominated debt, net capital exposures, and foreign currency transactions. Equity derivatives are used to mitigate financial risk embedded in certain insurance liabilities. The derivatives are effective economic hedges of the exposures that they are meant to offset.

In addition to hedging activities, we also enter into derivative instruments with respect to investment operations, which include, among other things, credit default swaps and purchasing investments with embedded derivatives, such as equity-linked notes and convertible bonds.

Credit Risk-Related Contingent Features

The aggregate fair value of our derivative instruments that contain credit risk-related contingent features that were in a net liability position at December 31, 2012, was approximately $3.9 billion. The aggregate fair value of assets posted as collateral under these contracts at December 31, 2012, was 4.3 billion.

We estimate that at December 31, 2012, based on our outstanding financial derivative transactions a one-notch downgrade of our long-term senior debt ratings to BBB+ by Standard & Poor's Financial Services LLC, a subsidiary of The McGraw-Hill Companies, Inc. (S&P), would permit counterparties to make additional collateral calls and permit certain counterparties to elect early termination of contracts, resulting in a negligible amount of corresponding collateral postings and termination payments; a one-notch downgrade to Baa2 by Moody's Investors' Service, Inc. (Moody's) and an additional one-notch downgrade to BBB by S&P would result in approximately $102 million in additional collateral postings and termination payments and a further one-notch downgrade to Baa3 by Moody's and BBB- by S&P would result in approximately $112 million in additional collateral postings and termination payments. Additional collateral postings upon downgrade are estimated based on the factors in the individual collateral posting provisions of the CSA with each counterparty and current exposure as of December 31, 2012. Factors considered in estimating the termination payments upon downgrade include current market conditions, the complexity of the derivative transactions, historical termination experience and other observable market events such as bankruptcy and downgrade events that have occurred at other companies. Our estimates are also based on the assumption that counterparties will terminate based on their net exposure to us. The actual termination payments could significantly differ from our estimates given market conditions at the time of downgrade and the level of uncertainty in estimating both the number of counterparties who may elect to exercise their right to terminate and the payment that may be triggered in connection with any such exercise.

Hybrid Securities with Embedded Credit Derivatives

We invest in hybrid securities (such as credit-linked notes) with the intent of generating income, and not specifically to acquire exposure to embedded derivative risk. As is the case with our other investments in RMBS, CMBS, CDOs and ABS, our investments in these hybrid securities are exposed to losses only up to the amount of our initial investment in the hybrid security. Other than our initial investment in the hybrid securities, we have no further obligation to make payments on the embedded credit derivatives in the related hybrid securities.

We elect to account for our investments in these hybrid securities with embedded written credit derivatives at fair value, with changes in fair value recognized in Net investment income and Other income. Our investments in these hybrid securities are reported as Bond trading securities in the Consolidated Balance Sheet. The fair value of these hybrid securities was $6.7 billion at December 31, 2012. These securities have a current par amount of $15.0 billion and have remaining stated maturity dates that extend to 2052.